Every business needs to spend money to run, survive, and thrive. However, how companies obtain financing to fund those expenditures can vary significantly, with some relying entirely on owner financing to those that lean heavily on debt financing. In our experience, many business owners are often hesitant to utilize debt and, even when they do, they do not always use it effectively. By optimizing the capital structure of a business, which includes optimizing the use of debt, owners can use “cheaper” third party sources in order to maximize return on equity.
Return on equity is an indication of how efficiently a business can generate profits, which can be simply calculated by dividing net income by the average equity balance. By investing less of their own equity and replacing that amount with third-party debt financing, owners can drive increases in their return on equity even after consideration of additional interest expense.
Yet, it is commonplace for business owners to be completely debt averse. They may worry that taking on additional debt could pose liquidity challenges, that involving a bank could somehow reduce the owner’s control over the business, or that borrowing could be a sign of weakness in the business. However, the opposite of all of these is often true. Reputable lenders are not in the business of lending so much that debt service could cause liquidity challenges. Additionally, good lenders can be great business partners given their vast experience serving other similar businesses. Finally, not utilizing leverage can actually weaken your business if your competitors can “out-invest” you and expand capabilities and cash flows. There’s also an additional benefit—because interest is tax deductible, the after-tax cost of debt is lower than the stated interest rate.
The key is for management to find the sweet spot between debt and equity. To do that, management can develop cash flow forecasts under a variety of scenarios to determine how much they need to fund major projects that improve the cash flow generation capacity of the business. Using those same forecasts, management can then change assumptions about the sources of capital and the resulting return on equity. Once armed with this information, owners can determine the optimal mix based on their risk tolerance and long-term goals.
Finally, by using third party capital, business owners can lower the amount of capital they have tied up in their business and provide them the opportunity to diversify their assets.
There is no one-size-fits-all approach to determining the right mix of debt and equity; however, striking the right balance can actually reduce long-term risk by helping owners build stronger businesses as well as diversity their overall risk. If you would like to learn more about capital structure, please contact us.